What is a Ponzi Scheme?
There are a number of ways investment fraud can be committed. Knowing the various strategies fraudsters attempt to use to take your money is key to knowing how to protect yourself. One of the most common investment frauds is a Ponzi scheme.
A Ponzi scheme is a fraudulent investment system where an individual, firm or company takes investment funds from a round of new investors and uses those funds, instead of profit from the business, to pay a "return" on the investment funds provided by an earlier group of investors.
Example:
Investor A purchases a $400,000 5-year Note 1 with a 15% interest rate, payable annually, from Borrower A. Borrower A uses the proceeds to purchase a multi-family rental property and plans to pay the interest with rental payments.
During the first year of Note 1, Borrower A makes timely interest payments to Investor.
During the second year of Note 1, several tenants fall behind on rental payments, causing Borrower A to default on the note. Borrower A and Investor A agree on changing the due dates for interest payments. Meanwhile, Borrower A sells a $200,000 5-year Note 2 with a 15% interest rate, payable annually, to Investor B. Borrower A plans to use these investment proceeds to pay Investor A's interest payments but does not tell Investor B of those plans.
During the third year of Note 1 and first year of Note 2, several tenants are evicted, reducing the cash flow from the rental property. Borrower A makes timely interest payments to Investor A using Investor B's investment proceeds from Note 2, but Borrower A falls behind on interest payments with Investor B, causing the parties to restructure Note 2. Borrower A sells a $150,000 5-year Note 3 with a 15% interest rate, payable annually, to Investor C. Borrower A plans to use these investment proceeds to pay Investor B's interest payments but does not tell Investor C of those plans.
By now, you can see where this is going...
To keep an operation like this stable over several years, the Ponzi scheme perpetrator must continually raise investment money to keep paying returns to earlier investors. Eventually, the schemes collapses when the investment funds can no longer be raised and payments can no longer be maintained. In many situations, Ponzi schemes begin as legitimate businesses and revert to fraudulent activity when promised returns cannot be achieved. The fact some begin as legitimate businesses makes detecting Ponzi schemes difficult, especially in their first few years, but with some research and critical thinking, it can be done.
If you feel you might be part of one of these scheme, feel free to contact me for a free consultation.
Notable Ponzi Schemes
How Bernie Madoff's $65 billion Ponzi scheme work [via Business Insider]
Nevin Shapiro charged in $900 million Ponzi scheme [via South Florida Business Journal]
Woodland Hills men get prison time for $134 million Ponzi scheme [via My News LA]
Scott Rothstein gets 50 years in $1.2 billion Ponzi scheme [via ABC News]